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March 17th, 2011 by

Homemade Absolute Return Strategy

Things are just not getting better with the disaster in Japan and the Middle East turmoil is still have not come to any conclusion. So where would a prudent investor invest to safeguard his/her nest egg? There is fear in the market and safety is the issue.

I have spoken several times about Absolute Return strategies on these pages. This is the “holy grail” of a prudent investor, where you achieve a superior risk adjusted return. Not the best returns relative to a raging bull market, but steady 1% per month returns no matter what market is going through, ups, downs or sideways.

So we want to achieve these results, how do we go about it? You can find some ETFs out there that do this, but there are few choices, so I have a suggestions for you. In fact what I suggest is create your own absolute return strategy. Something that is straightforward to understand and simple to execute.

What I am suggesting is to take a long position in a good quality fund (in this case a mutual fund, because we don’t have enough active ETFs with long enough history) and short an equivalent dollar amount with an index fund (in this case we can actually use an ETF, because they do have enough history).

Let me illustrate with the following example. I simply went to Yahoo and picked funds from their top performing mutual funds in the Large Blend, Large Growth and Large Value categories. These funds are NVORX, RBCGX and YAFFX respectively. I took their five year monthly returns and subtracted S&P 500 returns. I actually took the S&P 500 ETF which is SPY. The SPY is a more accurate representation of the S&P 500 index return, because you can actually own it, you can short it and you have to pay out dividends on holding a security short.

The results are very interesting.

Here are the results for fund total return, annualized return, volatility, Sharpe Ratio and correlation:

Fund Return NOVRX RBCGX YAFFX SPY
5 Year Total Return

71.67%

87.71%

69.83%

13.96%

5 Year Annualized Return

11.41%

13.42%

11.17%

2.65%

Volatility

18.99%

14.47%

19.84%

17.78%

Modified Sharpe Ratio

0.601

0.928

0.563

0.149

Correlation to SPY

0.840

0.655

0.884

1.000

 

As reminder, the Sharpe Ratio measures the risk adjusted return, i.e. return you earn relative to the risk you take. In the table above I use “modified” Sharpe Ratio, because in the formal calculation you would need to subtract risk free rate from the fund return, but to simplify this exercise I simply divided annualized return by volatility.

Now here are the results of the homemade absolute return strategy, where in my hypothetical portfolio I have a long position in the fund and I have a short position in the SPY:

Fund Return less SPY NOVRX RBCGX YAFFX
5 Year Total Return

48.73%

53.32%

48.43%

5 Year Annualized Return

8.26%

8.92%

8.22%

Volatility

10.46%

13.74%

9.26%

Modified Sharpe Ratio

0.790

0.649

0.888

 

Clearly in these hypothetical Absolute Return funds the returns go down, as you would expect, because you are taking away the SPY contribution (i.e. subtracting SPY return from the fund return). But what is highly important is that volatility decreased significantly for the two (NOVRX, YAFFX) of the three funds. In those two hypothetical Absolute Return funds, the volatility went down on the average by about fifty percent, while the returns went down on the average by about a third. This is the result we were looking for — the volatility decreased faster than returns.

One possible explanation why the RBCGX hypothetical Absolute Return fund did not improve Sharpe Ratio is because this fund is poorly correlated to the S&P 500 index, which we used as a hedge, so the comparison here is not apples to apples.

So here you go, start investing like a hedge fund with fairly straightforward and simple analysis. Now you can still get good returns, with much lower volatility and the result is that you can sleep better at night.

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